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China’s Military: What It Means for Markets
Investors
must prepare for the possibility of a Great Power conflict between the U.S. and
China.
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By
December 26, 2015
China’s factories are
now rapidly producing military capabilities that will eventually rival those of
the U.S. The only remaining debate is whether China will achieve parity by
2020, 2030, or later.
China’s capabilities
already include the world’s most diverse missile threat, the fastest-growing
diesel-electric submarine fleet, and new nuclear subs capable of striking any
city in the world with ballistic missiles. On the wings of stolen American F-22
and F-35 blueprints, China is also flying fifth-generation stealth fighters.
And its bold reach for the stars–planning moon and Mars missions and a
militarized space station–will increasingly bring the ultimate strategic high
ground within Beijing’s reach.
This rise of Chinese
militarism portends tectonic shifts—economic, geographic, and political. It
also means investors will win or lose fortunes.
Key portfolio
decisions will range from the pricing and hedging of geopolitical risk to asset
allocations across continents and countries. Bold traders will initiate
Soros-style exchange-rate bets in anticipation of conflict-driven currency
moves. The most opportunistic will tactically buy and short company stocks and
country index funds around major conflict flashpoints. These range from China’s
“renegade province” of Taiwan and a nuclearized North Korea, to the
resource-rich but dangerous waters of the East and South China Seas.
Looking
Ahead
A more sophisticated
understanding of geopolitical risk will be an investor’s best friend in a 21st
century of authoritarian aggression. Billions have already changed hands since
Russia’s Ukraine adventures began in 2014. As the ruble has plunged and partly
rebounded, German and U.S. bond prices have gyrated with flights to safety, and
volatile European bourses have alternated between fear of reduced trade and
hope of peace. A simple anticipatory short on an index fund for the Russian
market would have netted a nearly 50% gain.
It is an open question
whether a rapidly militarizing China will follow in Russia’s determined
footsteps. While some still argue (or hope) for a “peaceful rise,” former
Chinese leader Deng Xiaoping’s admonition to “seek truth from facts” quickly
leads to a forecast of significant conflict.
Like Russia’s Vladimir
Putin, China’s Xi Jinping is aggressively pursuing historical territorial
claims unsupported by modern international law. China asserts sovereignty over
80% of the South China Sea–one of the most strategic sea lines of
communication, through which a third of all shipping flows.
From
Shoals to Islands
To press its expansive
claim, China sends flotillas of white-hulled coast guard and commercial fishing
vessels backed up over the horizon by gray-hulled Chinese warships. Through
such coercion, China has already sliced disputed shoals, petroleum reserves,
and islands from the Philippines and Vietnam. Today, as the People’s Liberation
Army builds heavily armed garrisons on artificial reefs supporting 10,000-foot
runways, U.S. bombers and warships pass close in protest.
The East China Sea is
similarly tense as Chinese ships routinely violate the territorial waters
surrounding Japan’s Senkakus Islands. In nationalistic backlash, Japan’s
electorate has chosen a prime minister remolding Japan’s constitution to
facilitate remilitarization. Against this backdrop, the U.S. has publicly
reasserted its commitment to defend Japanese territory. Beijing, Tokyo, and
Washington could face a Sarajevo moment.
China’s long-running
bid to take Taiwan likewise portends conflict: Much of China’s militarization
has focused on low-cost “asymmetric weapons” like the DF-21D anti-ship
ballistic missile explicitly designed to sink the high-cost capital assets of
America’s aircraft-carrier strike groups. Would the next American president
risk sending aircraft carriers to the Taiwan Strait as Bill Clinton did in
defense of the island democracy in 1996?
Perhaps most
dangerously, Chinese and American warships spar frequently over their dueling
definitions of freedom of navigation. While the U.S. supports the
internationally recognized 12-mile territorial limit, China insists on
controlling commercial and military shipping as far as 200 miles from its
coast. China’s threat to freedom of navigation must be a clear red line, as a
200-mile limit would constrain access of American commercial interests to some
of the most lucrative markets in the world and effectively run the U.S. Navy
out of the Asian side of the Pacific.
Defensive
Investments
Any significant
conflict in Asia would immediately damage the highly interconnected global
supply chain and trading network, with all the negative implications for asset
prices any such geopolitical shock might entail. The question for money
managers is how to exploit tensions and conflicts.
The next several
decades should be very bullish for defense industry stocks. Already, China’s
aggressive behaviors have triggered an underwater arms race: Japan, South
Korea, Vietnam, and even Indonesia are shopping for submarines.
In the face of both
Russian and Chinese aggression—and against the backdrop of an emerging Putin-Xi
axis—the 2016 presidential campaign will also feature repeated calls for
building more ships, more submarines, more planes, and more elaborate air,
missile, and cyberdefense systems. The prudent investor seeking magnified
returns will follow the fundamentals and technicals of every publicly traded
company involved in this potential construction boom.
While there may be a
fine line between prudence and war profiteering, no investor should feel guilty
about preparing for the contingencies of a Great Power conflict with China.
This is a world in which the highest rates of return will be generated by
investors and traders with the most sophisticated geopolitical awareness.
Understanding the full range and scope of China’s militarism is where such
awareness must begin.
PETER NAVARRO is a
professor at the Merage School of Business, University of California-Irvine. He
is author of Crouching Tiger: What China’s Militarism Means for the
World (Prometheus Books, crouchingtiger.net).
